The Fed and the Naivete of Economic 'Control'

I taught IB mathematics at Atlanta International School for three years and have had more than my share of math courses in my life.  The classic question from frustrated or intimidated students was:  “When will I ever use this stuff!”

It is true that most people will rarely be tasked to solve algebraic equations or identify minimums or calculate derivatives in their work life.  But I would argue that an understanding of math and physics gives one an insight into the way that ‘systems’ behave that is invaluable in understanding many aspects of life.  And not just physical systems like planets, airplanes and human bodies, but also systems such as social systems, economics, political systems and general human behavior.

I did a masters degree focused on system dynamics and control theory, which I found to be a fascinating insight into almost everything!  The basic concept is that systems can be modelled mathematically and then controlled by either open loop or closed loop control scenarios.  Open loop means that the control is done with no feedback from the system itself and closed loop means that the feedback is used to alter the control input.

A simple example of a closed loop control system is an elevator.  The control input is the control signal to the motor that raises or lowers the elevator.  The position of the elevator is the measured quantity that is used as feedback to determine whether to increase or decrease the motor speed.  As the elevator gets closer to its desired position (floor), the motor speed decreases and is eventually stopped.

An elevator is a single input, single output system – very simple.  An airplane is an example of a much more complex system.  There are multiple control inputs – throttle, flap positions, rudder position, etc. – and there are multiple measured quantities that must be used as feedback to control the airplane – air speed, pitch, roll, yaw, elevation, etc.   This is a multi-input, multi-output system. 

Controlling an airplane is very complex, but fortunately the dynamic behavior of airplanes can be modelled quite successfully, and control algorithms can be mathematically derived.  Airplanes can be operated completely by computerized automatic pilots.

There are two critical questions for every system: (1) is the system ‘observable’ – i.e. are the available measurements sufficient to understand how the system is behaving?  And (2) is the system ‘controllable’ – i.e. are the control inputs sufficient to actually control the system?  To determine the answer to these questions one must have an excellent model of the system and its control inputs and measurements.  The more complex the system, the more likely it is that multiple measurements and control inputs will be necessary to 'observe' and 'control' the system.

 

Our economy is about as complex a system as one can imagine.  Attempts have been made to model it, but there are so many non-deterministic aspects of economic behavior (consumer attitude/action, political impact, weather, war, etc.) that models are at best a way to convey concepts and trends rather than accurate portrayals of behavior.  The economy is clearly a multi-input, multi-output system.  The lack of a comprehensive and accurate model makes it very challenging to derive any true control algorithm.

It is not clear whether the measurements we have of our economy are sufficient to make it ‘observable’ from a control point of view.   Similarly, it is also clear that multiple control inputs would be necessary to control such a complex system, if indeed it is ‘controllable’.

The primary ‘control’ input for our economy is the interest rate that the Federal Reserve (the Fed) establishes.  In times of stability and small perturbations of the economy, the use of this control input can seem to be effective in controlling many aspects of the economy.  But it is absurd to believe that this single control input can truly ‘control’ the economy in any real sense.  I suspect that most serious economists know this, as quantitative economics is a fairly well-developed discipline.

When the economy goes into recession, attempts are made to use other controls to bring it back to a healthier state.  Examples are deficit spending such as infrastructure investments, unemployment aid, quantitative easing and, in some cases, austerity measures.  There is great debate over whether these measures should be initiated and whether they are effective.  The simple truth is that there is really no way to know without a comprehensive model of the economy, which is unlikely to ever be derived.

When the economy has serious disruptions, the Fed is more or less helpless in guiding it to a more stable situation.  In these scenarios, the lack of ‘controllability’ of the economy is apparent and the world can only take shots in the dark to attempt to fix the problems.  It is naïve to believe otherwise, though many will claim to have the answer!  Fortunately, the economy is generally self-correcting, though not without a lot of pain and misery in the interim.